What should Central Banks do about Real Estate Prices? Franklin Allen and Elena Carletti Asset Prices, Credit and Macroeconomic Policies March 25-26, 2011 Idep-Greqam, Marseille, France

Real Estate Markets and Financial Stability Reinhart and Rogoff (2009) document that many financial crises are the result of a sharp drop in property prices In the current crisis Ireland, Spain and some regions of the U.S. had sharp run ups and then collapses in property prices that have had a severe effect on these countries’ banking systems and economies 2

3 Figure 1 Nominal housing Prices in Ireland, Spain and the U.S.

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What are the causes of these real estate bubbles? It is widely argued there are two important ones 1.Loose monetary policy – low interest rates 2.Global imbalances – easy availability of credit 5

Total Reserves in Billions of US $

Residential Mortgages 7

Figure 3 Current Account Deficits as % of GDP 8

The debate needs to go beyond Taylor’s (2008) assertion that low interest rates cause property bubbles if preventive policies are to be designed We need to model how property bubbles arise 9

Theories of bubbles 1.Infinite horizon (Tirole 1985, Caballero and Krishnamurthy 2006, Kocherlakota (2010), and Farhi and Tirole 2010) 2.Asymmetric information (Allen, Morris and Postlewaite 1993, Conlon 2004, and Dobles-Madrid 2010) 3.Agency problems (Allen and Gorton 1993, Allen and Gale 2000, 2003, Barlevy 2009) 4.Behavioral (De Long et al. 1990, Herring and Wachter 1999, Abreu and Brunnermeier 2003, and Scheinkman and Xiong 2003) 10

What should a theory of bubbles explain? In “normal times” there are not property bubbles (e.g. Germany for last 20 years) In “bubble times” there is a sharp increase in leverage and run up in property prices, then a collapse This distinction suggests there is a threshold where speculators enter and start a bubble We use an agency approach to model this 11

12 Normal times Willingness to pay for housing services Supply of housing services S 1 ’ Pr. π S 1 ’’ Pr. 1- π P 1 ’ = H(S 1 ’) P 1 ’’ = H(S 1 ’’) Risk neutral consumers determine prices

Bubble times Risk neutral speculators use their own wealth W and loan with loan-to-value ratio λ to buy x units at price P t so We focus on the case where there is no default when the price is high but there is when it is low so speculators enter if 13

In this case speculators enter and the price is bid up so this condition is satisfied with equality and there is a bubble if In the special case ρ S = ρ C = r 0 = r we can simplify the entry condition by substituting the borrowing constraint 14

In the special case λ = 1, W = 0 and ρ S = ρ C = r 0 = r In this case bubbles always occur 15

Policy considerations Objective of policy should be to prevent bubbles occurring in the first place and restoring normal times if speculators have entered Speculators’ entry condition more likely to be satisfied with low interest rates and easily available credit Monetary policy and credit availability can have a role to play in controlling bubbles in small homogeneous countries like Sweden but in large heterogeneous economies like China, the Eurozone and the U.S. macro-prudential policies need to be relied upon 16

Macro-Prudential policies Macro-prudential policies are designed to counter a whole range of systemic risks Countercyclical regulatory policy Control of contagion risk Discretionary policies 17

Macro-Prudential policies for real estate Should eliminate speculators’ incentive to enter the real estate market and create a bubble 1.Mandatory reductions in loan-to-value ratios 2.Increases in annual real estate taxes 3.Increases in taxes on real estate transfers 4.Direct restrictions on real estate lending 18

Implementation of macro-prudential Borio and Lowe (2002) and other papers from the BIS suggest difficult but not impossible to identify property bubbles Christensson et al. (2010) look at Financial Stability Reports of the Netherlands, Norway, Spain, Sweden, and the U.K. over the period preceding and during the crisis FSRs were successful in identifying risks and unsustainable trends but many were regarded as low probability events not worthy of action 19

Chinese experience The Chinese have tried a number of these measures – Lower loan-to-value ratios for second, third, and more houses – Taxes on resales of certain types of housing – Restrictions on foreigners buying – Loan restrictions on commercial property They have not worked very well in the major cities 20

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Concluding remarks Objective of policy should be to prevent the property market becoming speculative Monetary policy and credit availability can have an important role in some economies like Sweden It is not clear that macro-prudential policies will prevent or eliminate bubbles but they may help Inefficiency of property markets is also important, i.e. positive serial correlation of returns (e.g. Englund, Quigley and Redfearn 1998), and needs to be incorporated in the analysis 24